NY futures came under pressure since our last report of December 17, as March gave up 156 points to close at a three-month low of 61.43 cents.

Instead of cheers the New Year has brought fears to financial markets, as a deteriorating macro environment has prompted many traders to adopt a “better safe than sorry” attitude. Although there are currently plenty of economic and geopolitical trouble spots around the globe, China is clearly at the center of everyone’s attention at the moment, since it has been the engine of global growth over the past two decades.

From a commodities’ perspective China has grown into the largest importer of energy, base metals and agricultural products over the years, and therefore the prospect of a sluggish Chinese economy has not been kind to commodity markets.

In addition to weak growth, traders are also worried about the depreciation of the Chinese yuan, which has accelerated again this week, with the offshore rate trading as low as 6.76 yuan to the dollar, whereas the onshore rate has so far been contained at around 6.56. A lower yuan is likely to put further pressure on emerging market currencies, which have already taken a severe beating last year.

These “currency wars” create a variety of issues and are particularly bad for countries with high inflation and/or dollar-denominated debt. They raise the cost of imports, which leads to higher local prices and slower consumption, while they stimulate production of exportable items. However, since the middle class in the US and Europe doesn’t seem to have the same spending power anymore and China’s economy is cooling off as well, we may end up with too many goods for which there are not enough buyers.

This in turn produces deflationary pressures and deleveraging, which is troublesome in a highly indebted global economy. Before the academics at the various central banks started messing with the business cycle, excesses were periodically purged out of the system by recessions, which would set the stage for the next upturn. Nowadays the misguided solution is to print trillions of US dollars, Euros and Yen, and to keep interest rate near zero, which has only served to create even bigger bubbles and misallocations.

Cotton was one of only four commodities that ended 2015 higher – the others being cocoa, sugar and orange juice. This relatively strong performance was attributed to two factors, namely the sharp drop in global production and China’s willingness to hold its large stockpile off the market.

We believe that when the final tally is in, global production for the 2015/16-season will be right around 100 million bales (USDA is currently at 103.7 million bales), since our production numbers for China, India and Pakistan are all lower than the latest USDA estimate. If our assumption were correct, it would mean that global output is around 19 million bales less than last season and over 20 million bales below that of two years ago. Just imagine where cotton prices would be without such a steep drop in production!

As stated previously, the ROW balance sheet is shaping up to be the tightest since the 2009/10-season, with ending stocks of around 39 million bales, or some five million bales less than last summer. Therefore, a bullish case can certainly be made for the latter part of the season, as stocks are expected to get rather tight, especially for premium qualities.

However, the above assumption is predicated on China continuing to keep its massive inventory locked away, and this may be too much to ask for. Last year China tried to offload some of its stocks, but didn’t succeed because of uncompetitive pricing and quality concerns by buyers. But there will likely be another push to offload some of this burdensome asset, which has a current market value of an estimated 13-15 billion dollars, possibly into export channels as well.

US export sales continued at a pedestrian pace of around 100,000 bales per week over the holidays, but shipments have started to pick up and amounted to over 172’000 running bales in the latest report. Total commitments for the season are now at 5.4 million statistical bales (vs. 7.9 million bales last season), of which 2.5 million bales have so far been exported (vs. 2.6 million bales last season).

So where do we go from here? Market jitters have been weighing on commodity markets, with crude oil leading the way lower. The worry is that these depressed commodity prices and emerging market currencies will eventually lead to defaults and bankruptcies, causing a rout in bond and stock markets. We have seen these turbulences before, but the current one seems to instill the greatest fear among traders since the financial crisis of 2008. Central banks will certainly stand by to inject another round of liquidity if needed, although the market is beginning to question its effectiveness.

As far as cotton goes, there is a risk that financial contagion could lead to a credit event like in 2008, when hedge funds were forced to meet margin calls by selling liquid assets such as commodity futures. The latest CFTC report showed that speculators owned 8.3 million in outright longs and 2.9 million in outright shorts, giving them a net long position of 5.4 million bales. Judging by the still rather high open interest there hasn’t been much liquidation yet, but we definitely need to keep an eye on further developments in the financial sphere.

However, barring a financial meltdown, there are definitely some bright spots among all this doom and gloom. We can’t remember a time when both interest rates and energy prices have been so cheap, which is providing a boost to consumers around the globe.

For now the market is still in a sideways trend, which has been in force since September 2014. If it weren’t for these macro fears and the threat of Chinese stocks hitting the market, the outlook for cotton prices would actually be quite friendly going into the second half of the season and if outside markets were to calm down, this scenario might still play out. However, given the current uncertainties, we would recommend buying some cheap downside protection, just in case!